Sunday, April 5, 2009

IU Econonics Forum

We had an Economics Forum at IU on Friday afternoon. There were several excellent talks put on by very bright economists with ties to IU. Here is a link to all presentations. George von Furstenberg's talk goes over the legal grounds upon which the growth in power of the Treasury, the FDIC and the Fed rests. Unfortunately his comments and turns of phrase cannot be completely gleaned from his slides.

Myself, I tried to explain how standard open-market operations were used to influence the overnight market for liquidity. I attempted to construct an example of IU undergrads lending excess cash to each other to have while they go on dates. The collateral they put for the overnight trades is video games. High quality video-games can be thought of as short-term Treasuries. A guy called Ben uses video-games to control the supply of excess cash--too much cash and the dating market overheats--too little cash and too few people go on dates.

We can think of the onset of the crisis by imagining there are a set of students at IU who go on dates, but don't get to trade directly with this guy Ben. Instead, they create their own video games that work as collateral in the overnight market. Particularly, a couple of guys started to issue `sub-prime' video games. Initially people liked these games, but in the summer 2007 people playing the games realized they were junk. These games were now lemons, and the overnight lending market froze up. Things got so bad in September 2008 that Ben's trading in money and high-quality games become impotent. Essentially, people preferred to keep their money, rather than lend it out or go out on dates. Money and high quality video games were now perfect substitutes, now serving as a store of value. The students at IU were afraid that if they lent, they would become insolvent and they would never be able to go on dates again. Ben doesn't like this situation, so he has now started to trade other types of video-games for money. For instance, he trades lower quality games and games that last longer--such as fantasy or war games that take longer to finish. This creates more liquidity for video-games, but if it will convince the students to go out on dates, we do not yet know. It's not clear how this liquidity solves the insolvency and lemons problems. It does however stem the liquidity problems that have arisen from the insolvency and lemons problems.

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